Question

1. The economy of Maxistan is currently in a recession. Show the current short-run equilibrium in a correctly labeled graph of the aggregate demand, short-run aggregate supply, and long run aggregate supply curves. Let Y1 represent current output, Yf represent full employment output, and PL1 represent the current price level. 2. Suppose interest rates are lowered. Show the effect this will have on the economy of Maxistan in your graph. Let Y2 represent the new output and PL2 represent the new price level.

Answer 1

1. The recession is period of contraction, in economic activity. It is characterized by low level of output income, employment and low prices. During this period unemployment will be greater than the natural level. Economy's output fall below the potential level. Aggregate demand falls short of aggregate supply, the price level reaches to the low minimum. A recession is generally caused by a negative demand shock Price level LRAS SRAS ADI AD Yi YC GDP A negative demand shock shift the aggregate demand curve leſtward from AD to AD1. This reduces the aggregate price level from PL to PL1. The actual GDP of the economy decrease below the potential level. The GDP declines from Yf to Y1. 2. During the period or recession the central bank follows an expansionary fiscal policy which lowers the rate of interest. The fall in interest rate stimulate more consumer spending and investment spending. The increase in aggregate spending shifts the aggregate demand curve to the right. Then output expands and cmployment and price level increase. Price level LRAS SRAS PLA PL2- TAD2 AD TADI Y1 Y2Yf GDP In the above figure PLI and Yl represents price level and output when the cconomy experiencing recession. The monclary expansion lowers the interest rate and the aggregate demand curve shift from AD1 to AD2. It increases the price level from PLI to PL2 and GDP from Y1 to Y2 in shortrun.